Home prices in Canada are overvalued by 14 per cent, while affordability is eroding dramatically in some parts of the country, say two new reports on the state of the housing market.

“When it comes to prices, by almost any measure, Canadian home prices are overshooting their fair value,” CIBC senior economist Benjamin Tal said in a report Tuesday. “The pace of appreciation has been quicker than justified by housing market fundamentals.”

The bank says the average price of a home has risen by almost 23 per cent since the cyclical low of January 2009, and about 7 per cent above recession levels.

As a result, at least 1.5 million homes across Canada are overvalued, particularly in western Canada, and a price drop of 5 to 10 per cent over the next 12 months would not be unlikely, said Tal.

The CIBC report echoes other recent analyses, including one from the the TD Bank that says housing prices are overvalued and due for a fall. Earlier this month TD reversed course on its forecast and predicted a 2.7-per-cent drop in prices in 2011 instead of a 1.6-per-cent increase.

However, Tal said just because prices are high, there won’t necessarily be a crash.

“A violent market correction needs a trigger such as the sub-prime crisis which ignited the U.S. real estate meltdown, or abnormally high interest rates as was the case during the 1991 property crash in Canada,” said Tal.

Just because prices may be 14 per cent overvalued does not mean that prices will come down immediately by 14 per cent, said the economist. A more likely scenario is that prices may drop by anywhere from 5 to 10 per cent over the next year. After that the market may stagnate and allow pricing to catch up.

“What we will see is a much less exciting market with prices going nowhere until mid-decade,” said Tal. “But that is certainly not a crisis.”

In Ontario, Tal estimates that home prices are 11.7-per-cent overvalued based on historical norms. Much of that upward pressure has been driven by the heated Toronto market.

As a result, strong property values in Ontario have caused affordability to erode dramatically over the first quarter of 2010, according to a separate report Tuesday by RBC Economics.

The strength of the market has caused the bank to warn that some buyers are being shut out, and that affordability will continue to decrease over the next year as interest rates go higher.

“Stress is definitely starting to build in the Toronto market,” said economist Robert Hogue.

The Toronto market hit new heights in terms of existing home sales and price appreciation during the first quarter, which caused affordability to erode.

The Canada Mortgage and Housing Corp. says average prices will hit a record $444,000 in the Toronto market by the end of the year, and existing home sales will break the 100,000 mark for the first time.

According to RBC, it now takes 49.1 per cent of pre-tax income to afford a bungalow in the city, up 0.4 percentage points from the prior quarter.

“All Toronto housing affordability measures now exceed their long term average, suggesting that the market’s dizzying flight could soon run into some turbulence,” warned Hogue.

RBC said the implementation of the Harmonized Sales Tax in Ontario on July 1, which will increase transaction costs for purchases, has boosted sales as buyers and sellers rush to beat the deadline.

The Bank of Canada is also expected to raise its key interest rate as early as June 1, which could cause affordability to erode as borrowing costs go higher.

CIBC’s Tal said despite the recent drop in affordability, it takes about 15.6 per cent of pre-tax income to afford a home today (not including expenses such as hydro bills and property taxes), the same as about 10 years ago.

Older Canadians with income of less than $50,000 are suffering the most, said the bank. However, one bright spot is that the least vulnerable mortgage holders, those over 35 with incomes over $50,000, have grown to 65 per cent of the market from 50 per cent of the market a decade ago, which should provide some cushion to the economy.

Meanwhile, the market has been so strong that even a strong rush of listings have failed – at least so far – to bring prices down.

“Despite an increased supply of homes on the market, prices continue to rise, which has undermined affordability,” said Hogue.

The higher the figure in the RBC index, the more unaffordable the property. Total home ownership costs include mortgage payments, utilities and property taxes.

Still, Toronto looks positively affordable when compared with Vancouver, where it takes 73.4 per cent of pre-tax income (up an astounding 4.8 percentage points over the previous quarter) to afford a bungalow.